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SEC Refuses to Allow Financial Sector Firm to Omit Shareholder Proposal Concerning Disclosure of Climate Change Risk

As a member of an international consortium working to find ways to encourage companies to pay attention to climate change and other environmental matters, (more information on the project here), I was interested to see that the SEC recently refuse to allow PNC Financial Services Group, Inc. to omit from its proxy materials a shareholder  proposal seeking disclosures concerning the impact of the company’s activities on climate change.    (SEC NO-Action letter, not yet available.) 

Specifically, the proposal asked the PNC board of directors to disclose its “assessment of the greenhouse gas emissions resulting from its lending portfolio and its exposure to climate change risk in its lending, investing, and financing activities.”  Shareholder proposals relating to environmental issues generally and climate change specifically are being filed with some regularity, due in some part perhaps to the SEC issuing guidance on climate change disclosure in 2010. (available here).  In that guidance the staff made clear that the standard for disclosing climate change risks is the same as for any other risk:  if the risk is material is should be disclosed.   Additionally, the same grounds for exclusion that apply to other shareholder proposals are also available to companies seeking to exclude proposals touching on environmental concerns.

PNC, like many other companies, tried to block inclusion of the shareholder proposal  on the ground that it dealt with ordinary business operations and therefore was properly excludable under Exchange Act 14a-8(i)(7).    Because PNC is afinancial services company it is expected to make risk assessments as part of its business and thus the SEC could easily have concurred with the company’s argument that the shareholder proposal raised “day-to-day choices [made by the company] in extending credit, managing assets, and investing capital, and how PNC measures the totality of the risk associated with doing business with particular companies or making certain investments.”

The SEC did not accept PNC’s argument however, and instead noted that “the proposal focuses on the significant policy issues of climate change” thereby making the proposal properly excludable.  The issue presented turned on whether there was a sufficient connection between PNC’s activities and climate change.  The SEC was careful to note that the decision “does not represent a view on the need for the financial sector to consider the issue of climate change.”  Instead, its decision was based on the particular facts presented, including the fact that PNC itself represented that there was a strong relationship between its activities and climate change.  The bank had stressed the importance of regulating climate change impact as part of its reputation and stated that it performs a “supplemental evaluation for companies in the extractive industries, including an understanding of any significant environmental impacts.”  By so linking its business operations with the significant social issue of climate change, PNC took the issue out of being one of ordinary financial institution risk assessment and therefore lost the right to exclude it on those grounds.

The long-range implications of this letter remain to be seen.  Of course, a no-action letter has no legal import beyond the precise issue addressed in the particular letter and as to the precise company identified in the letter.  On an informal basis, however, such letters carry great weight.  Companies may respond in a number of ways to the PNC no-action letter decision.  Among other steps, they might increase their environmental reporting of their own volition so as to stave off shareholder proposals on the matter, or they might tone down the level of rhetoric they engage in touting their environmental “propriety” (“greenwashing”?). 

Regardless of the precise steps taken, the PNC no-action letter suggests that it may be more difficult for companies to dodge disclosure of the impact of their activities on climate change and other environmental issues in the future.


The Promise and Risk of Crowdfunding: Inocente, Kickstarter, and the Oscars

The Oscars were an effective commercial for the promise of crowdfunding.  The short movie, Inocente, won an Oscar in the category of "Documentary Short Subject."  The film raised $52,527 from 294 contributors, representing approximately one-fourthof the total funding for the film.  The amount apparently paid for the post-production process.  The funds came in from an appeal over Kickstarter.  Apparently other nominees also raised money from Kickstarter. 

The success of Inocente shows the promise of crowdfunding.  Projects that cannot raise funds through conventional means can appeal to contributors over the Internet and sometimes access the necessar funds.  They need something that appeals to one's emotion, reputation, or creative senses.  Inocente involved a homeless girl who manages to hold onto her art.  The story was compelling and not surprisingly the crowd responded.   It is an example of how crowdfunding in the realm of movie/music can provide an  unconventional source of funding for creative ventures and future Oscar winners.

The Inocente approach, however, is not really the model chosen by Congress in the JOBS Act when it permitted crowdfunding offerings of equity securities.  In raising $52,527 from 294 contributors, Inocente received checks that averaged $178.66.  In other words, the Kickstarter model was to allow many contributors motivated by reputation or emotion to write small checks to fund a particular project. 

Crowdfunding in the JOBS Act, in contrast, allows for investments of up to $100,000.  In other words, Congress did not set up a model that contemplated small investments based upon emotion or reputation.  Instead, Congress allowed investors to expend a significant portion of their net worth on crowdfunding offerings.  Nor will this be lost on issuers offering securities.  Indeed, why seek out 294 contributors when, under the JOBS Acting, one investor will do. 

These investors will not be willing to settle for emotional satisifaction or a reputational credit at the end of a movie.  They will expect a real return on their investment.  As a result, they require significant protections under the federal securities laws.  The protections, in turn, add cost and complexity to crowdfunding offerings, making them less viable.  Had Congress imposed more restrictive caps on investments, these sorts of regulatory protections would be far less necessary.  Able to invest only a small amount that an investor could afford to lose, investors would need fewer protections.  But this is not the approach taken by Congress in adopting the JOBS Act. 


Teaching Moments in the Area of Corporate-Securities Law: The Dell Buyout and the Apple/Einhorn Dispute (Part 4) 

Lesson number 2 in the Apple-Einhorn concerns strategy and advice.  As part of the classroom exploration of various legal matters, its useful to get students to think of themselves in the role of counsel.  What advice might you give?  How might you structure matters?  What factors and variables should you take into account?  The facts in the struggle between Apple and Einhorn are a perfect forum for posing these questions. 

Einhorn placed Apple in a difficult spot.  According to the Complaint, he approached the company seeking a change in the proxy statement in early February.  The proxy statement had combined a group of proposed amendments to the articles (including the repeal of the blank check stock provision) into a single shareholder proposal. (See Apple Proxy Statement, Proposal 2). Presumably this was mostly a matter of convenience.  Rather than list every single change on the proxy card (there were five other proposals) and be required to provide a tally for each proposal, it was logistically simpler to combine related proposals, particularly where they were all likely to pass.

Einhorn, however, could point to the language in Rule 14a-4.  The provision required issuers to "identify clearly and impartially each separate matter intended to be acted upon".  This essentially required companies to unbundle proposals.  Einhorn wanted Apple to break the blank check stock provision out as a separate proposal.  As the Complaint asserted, he made his request to the company in early February.

With the meeting schedule for Feb. 27, Apple faced several imperfect choices.  The company could refuse to change the proxy materials and run the risk of litigation.  If management lost, the company would find itself with an injunction either prohibiting a shareholder vote on the matter or requiring a revised proxy statement.  That could result in a delay in the meeting (with the possible need for a new record date and the resending of all proxy materials) or a decision not to have a vote on the article amendments.

Alternatively, the company could give in, creating the impression that it had knuckled under to Einhorn by unbundling the provisions when he made his demand, but presumably get the materials distributed in time to hold the meeting on Feb. 27. 

Add in three variables.  First, even assuming Apple thought it could win the injunction battle, there was always a risk it could not.  There is not much law around Rule 14a-4 and the proxy statement plainly combined a number of article amendments into a single proposal.

Second, had the company agreed to the Einhorn demand early in the month, allowing for a vote on the blank check stock provision at the Feb. 27 meeting, it is hard to believe that Einhorn would have won.  Plenty of shareholders would have supported the amendment because it was favored by management.  Plenty of other shareholders would have favored the amendment because it would reduce management's authority and enhance theirs. 

Third, the lawsuit was just one salvo in an ongoing battle between Apple and Einhorn over the disposition of the mound of cash held by Apple.  Any strategy taken with respect to the unbundling had to be considered in the context of the long game between the two adversaries. 

So there were any number of options and advice counsel might have provided.  Apple chose to fight and the result was an injunction against the company and a court order requiring that the proposal be unbundled.  The opinion and the briefs are here.  The court enjoined Apple "from (1) certifying or accepting proxy votes cast in connection with Proposal No. 2, (2) amending its Articles based on such votes, or (3) proceeding with its shareholder meeting in violation of SEC rules concerning Proposal No. 2."

The lesson in the classroom is, in part, the role of the lawyer.  In this case, the legal issues toook place in a broader context.  Lawyers get to be at the table because the legal parameters matter.  While at the table, they often get to provide advice that goes beyond pure legal analysis.  The breadth of the participation, however, ultimately depends upon the quality of the advice.  Beginning the process of teaching students these skills is one of the many functions of a legal education.  


Matambanadzo on "The Body, Incorporated"

Sarudzayi M. Matambanadzo has posted “The Body, Incorporated” on SSRN.  Here is an excerpt from the abstract:

This Article addresses the current controversy surrounding legal personhood by focusing on how legal personhood for corporations has been constructed by jurists and scholars in historical and contemporary contexts. This Article does so through an examination of the metaphorical use of the human body as an anchor for determining the status of corporations as legal persons. This analysis shows that even for corporations — disembodied, legally constructed entities lacking many of the rights and privileges of personhood — the human body serves as an important framework for shaping the legal community of persons and resolving theoretical disputes concerning those legal persons.

This Article also presents a novel theoretical justification of corporate personhood embedded in the legal tradition of the United States: the embodiment theory of the corporation. The embodiment theory of the corporation — deployed by courts, scholars, and lawyers — reveals how the embodied human being serves as the paradigmatic person of law. In the embodiment theory, human beings provide a model for determining how legal recognition functions for entities, collectives, and individuals — even those that are disembodied and legally constructed. For this reason, this Article argues that future efforts to determine the boundaries of legal personhood should incorporate human embodiment as a guiding framework for thinking about who “counts” in the community of persons.


Executive Director of the Lowell Milken Institute for Business Law and Policy at UCLA School of Law

We received this email from our friends at UCLA School of Law:


The UCLA School of Law is seeking a highly talented, experienced individual to be the Executive Director of the Lowell Milken Institute for Business Law and Policy at UCLA School of Law.  The Institute's mission is to bring world class policy analysis, research and educational opportunities in business law and policy to UCLA, the broader community of Southern California, the nation and the world.

The Executive Director will plan and oversee all aspects of the Institute's programs, which are designed to support and expand research, policy analysis, and teaching (including clinical teaching) about business law and policy at UCLA School of Law.  The Executive Director will help to develop the business law curriculum, including improving and expanding the Business Law Specialization for law students.  The Executive Director will also supervise fellows, policy consultants, research assistants, student interns, and volunteers; engage in fundraising; and organize symposia and other academic programs related to the advancement of business law and policy.  The Executive Director will work closely with the Faculty Director, members of the business law faculty, and the advisory board of the Institute.

Minimum requirements include an excellent academic record; a J.D., M.B.A. or equivalent advanced degree from a U.S. school; at least five years of successful business law practice or business experience; demonstrated management, administrative and organizational skills, with successful prior experience in fundraising or coordinating scholarly or professional conferences preferred; prior successful teaching experience and a record of publications concerning business law and policy topics preferred; and a strong record of established relationships with other business professionals and with professional organizations preferred.

The level of appointment will be commensurate with qualifications and experience.  This is a full-time, academic, non-tenure track position.

Confidential review of applications, nominations and expressions of interest will begin immediately and continue until an appointment is made.  Please apply online at by submitting a cover letter, resume, and the names and addresses for at least two professional references to the attention of:

Edna Sasis
Office of the Dean
UCLA School of Law
Box 951476
Los Angeles, CA 90095-1476

The University of California is an affirmative action/equal opportunity employer, and seeks candidates committed to the highest standards of scholarship and professional activities and to a campus climate that supports equality and diversity.


Teaching Moments in the Area of Corporate-Securities Law: The Dell Buyout and the Apple/Einhorn Dispute (Part 3)

The battle between David Einhorn and Apple is in many ways an even more interesting teaching moment.  The battle not only involves interpretations of the proxy rules (something inevitably reviewed in any securities class) but also the application of the blank check stock provisions (a staple of many classes on corporations or business entities).  

Blank check stock provisions are common (one suspect universal).  They provide management with the authority to create, by board resolution, a new class of stock.  The description of the new class is filed with the applicable state office and becomes part of the articles of incorporation.  In other words, the provision represents the most significant example of the board having the power to amend the articles of incorporation without shareholder approval (there are other more ministerial amendments that boards can also make). 

Blank check stock provisions are viewed as necessary because boards need the flexibility to quickly adopt new classes of stock.  An investor who wants to invest but insists on a dividend preference may not want to wait around for the new class of stock to be approved by shareholders, something that can entail a time consuming process.  Less discussed, there is the risk that shareholders will not approve the new class.  Particularly in the case of a preference class of stock, common shareholders may view themselves as disadvantaged by the new class and not approve its creation.

Because these provisions augment board authority, any effort at repeal would most likely come from shareholders.  Shareholders might be willing to deprive the board of the authority to act quickly to create a new class of stock in order to have a veto over the creation of a new class that they might find disadvantageous.  Boards, on the other hand, would generally oppose efforts to eliminate blank check stock provisions (something, as an article amendment, they have to initiate) since it reduces their discretion in connection with the management of the company.

Lesson number 1 in the classroom is that anything taught as a general rule likely has exceptions.  Thus, the battle lines in the Apple-Einhorn conflict took the traditional positions with respect to blank check stock provisions and stood them on their head. 

On the one hand, the Apple board has proposed a repeal of the blank check stock provision, effectively agreeing to reduce its own authority.  The approach is opposed by a shareholder of Apple, David Einhorn.  Einhorn wants the board to retain the authority to issue new classes of stock, even those that could be disadvantageous to common stock holders.  Thus, Einhorn wants more authority for the board and less for shareholders. 


Teaching Moments in the Area of Corporate-Securities Law: The Dell Buyout and the Apple/Einhorn Dispute (Part 2) 

The Dell buyout involves another interesting teaching moment.  Whatever dispute exists about the fairness of the price, the transaction builds in a safety valve.  It contains a "go shop" clause that permits other offers in the interum.  As the Form 8-K describes:

Pursuant to the terms of a “go-shop” provision in the Merger Agreement, during the period beginning on the date of the Merger Agreement and continuing until 12:01 a.m. (New York time) on the 46th calendar day thereafter (the “No-Shop Period Start Date”), the Company and its subsidiaries and their respective representatives may initiate, solicit and encourage any alternative acquisition proposals from third parties, provide nonpublic information to such third parties and participate in discussions and negotiations with such third parties regarding alternative acquisition proposals.

Companies submitting a "Superior Proposal" (or a proposal that could "reasonably expect to be Superior") can continue to negoitate after that time period.  A Superior Proposal?   A proposal that "would be more favorable to the Company’s stockholders than the Merger, taking into account all of the terms and conditions of such acquisition proposal (including the financing, likelihood and timing of consummation thereof) and the Merger Agreement (taking into account any adjustments to the Merger Agreement . . )"  The determination as to whether a proposal qualifies as "Superior" will be determined by the Special Committee "in good faith, after consultation with outside counsel and its financial advisors" .  .

At the end of the 45 day period, the "go shop" switches to "no shop."   

Beginning on the No-Shop Period Start Date, the Company will become subject to customary “no shop” restrictions on its, its subsidiaries’ and their respective representatives’ ability to initiate, solicit or encourage alternative acquisition proposals from third parties and to provide information to or participate in discussions or negotiations with third parties regarding alternative acquisition proposals.  

The provision provides that upon the acceptance of a Superior Proposal (a proposal initiated in the "go shop" period), there will be a $180 million walk away fee.  To the extent another offer is accepted that was initiated in the no shop period, the walk away fee will be substantially higher, at $750 million.   

So where does this go in the classroom?  In an area of law still steeped in a law and economics vocabulary, the "go shop" approach allows for a discussion of the role of the market in determining price adequacy.  Certainly if the company is actively marketed, putative bidders have equal access to confidential information, and they have enough time to put together a superior offer (including lining up the financing), shareholders may end up doing better or, if not (because no superior offer arises), they will presumably take some comfort that the received an adequate price.

But for the market to provide adequate information, the market has to be allowed to function.  Whether 45 days is enough to put together a deal, for example, is unclear.  The "go shop" provision provides considerable discretion to the Special Committee on determining whether an offer is "Superior." 

Moreover, some companies executing a "go shop" provision have actively marketed the company.  See Broc Romanek, DealLawyer, 2006 ("The most prominent example so far was when Maytag agreed last May to be sold to Ripplewood Holdings. But the agreement included a go-shop provision, and Maytag put it to work. After signing up and announcing its deal with Ripplewood, it canvassed more than 100 other bidders and smoked out Whirlpool to make an offer worth $1.36 billion, which it accepted only after a mini-bidding war that pushed the price even higher, to $1.7 billion.").  It remains to be seen how the Special Committee at Dell will handle the "go shop" authority.

Thus, the "go shop" provision used in the Dell offer may provide a market check on the adequacy of the price offering in the buyout, but whether it does will depend upon the details of the "go shop" provisions and their pratical implementation.  


Teaching Moments in the Area of Corporate-Securities Law: The Dell Buyout and the Apple/Einhorn Dispute (Part 1)

In teaching corporations and securities, I pull developments from the news to illustrate legal points.  Some may view this as a waste of classroom time but in my opinion students will remember the legal framework better if they can attach it to an actual example.  This semester, the buyout at Dell and the battle between David Einhorn and Apple involve interesting teaching moments.  I thought I would discuss the developments and illustrate how they might be relevant to class material. 

Dell involves a management buyout.  Michael Dell, the CEO, along with other investors, is seeking to buyout the public shareholders of Dell.   The case illustrates the application of the duty of loyalty.  With Michael Dell serving as chairman of the board, he is serving on the body that ultimately has to decide whether to accept his offer.  Given this potential conflict of interest, boards have the burden of showing that the transaction (in this case the buyout) was "entirely fair." 

Where, however, the board sets up an approval mechanism that is designed to expunge the conflict of interest, courts will presume that the transaction is fair.  For this to occur, the board must create a Special Committee that excludes interested directors (and those beholden to the interested directors).  In addition, the Special Committee must have access to independent advisors.  This is exactly the approach taken by the Dell board of directors.

The offering provided for the right of each shareholder of Dell to receive $13.65 in cash.  According to a current report on Form 8-K filed by Dell, the board formed a special committee consisting "solely of independent and disinterested members".  The Committee unanimously concluded that the transaction was "fair to, and in the best interests of, the Company and its stockholders" and unanimously recommended that it be approved by the full board, which the board did unanimously (other than Mr. Dell).  

The Company issued a press release that fleshed out some of the details of the treatment of the transaction.  First, the deal involved a premium over market price.   

The price represents a premium of 25 percent over Dell’s closing share price of $10.88 on Jan. 11, 2013, the last trading day before rumors of a possible going-private transaction were first published; a premium of approximately 35 percent over Dell’s enterprise value as of Jan. 11, 2013; and a premium of approximately 37 percent over the average closing share price during the previous 90 calendar days ending Jan. 11, 2013.

Second, the Special Committee was formed in August when Mr. Dell approached the board.  The Committee was led by Alex Mandl, the board's lead director.  Publlished reports indicate that the Committee also included Laura Conigliaro, Ken Duberstein and Janet Clark, all listed as independent directors.  See Proxy Statement, at p. 12.

These directors look to be a skilled bunch.  Clark is an EVP and CFO of Marathon Oil; Conigliaro, now retired, was a partner at Goldman; Duberstein is the chairman and CEO of a strategic advisory and consulting firm and the former chief of staff to President Reagan; and Mandl, the non-Executive Chairman of Gemalto N.V., a digital security company resulting from the merger of Axalto Holding N.V. and Gemplus International S.A.

They also relied upon the best of advisors.  Financial advice came from J.P. Morgan; legal advice from Debevoise & Plimpton LLP.  

From a teaching perspective, therefore, Dell took all of the right steps.  It formed a special committee, stocked it with talented and independent directors, and allowed the committee to retain skilled advisors. Shareholders are protected by sufficient process that ensures an elimination of any conflict of interest.  In the classroom, the lesson could stop there.

Only there is more to the story.  First, some shareholders have objected and announced that they will vote against the transaction. Second, a column in Sunday's NYT (Gretchen Morgenson) debated whether there should be an independent, peer-reviewed analysis of Dell’s enterprise value.  This approach had been proposed by The Shareholder Forum in a letter to Mr. Dell, as Chairman, and Mr. Mandl, as Presiding Director and chair of the Special Committee. 

There is not a single correct price for Dell.  The Delaware approach relies on process to ensure that the ultimate price is a fair one.  The opposition by some Dell shareholders and the proposal for an "independent, peer-reviewed" analysis of the Company's value suggests that there is doubt that the existing set of procedures are adequate to protect shareholders. 

Indeed,  the Delaware courts obliquely admitted this in the Americas Mining case.  In that case, the board formed a special committee consisting of independent directors.  Independent advisors were hired.  Yet the committee approved a transaction that the courts more or less viewed as inexplicable.  Rather than question the integrity of the process, they decided that the special committee was operating under a  "controlled mindset."  The case contained no meaningful evidence of this other than concerns with the way the process actually operated and the result.

In the end, this suggests that the process employed by the Delaware courts is not always sufficient to protect the interests of shareholders.  It is a good place to discuss ways of improving the process in order to better protect shareholders.  Of course, the discussion is, as we say in the business, academic since the Delaware courts are not likely to implement significant changes in the area. 


Teaching the Derivative Suit Demand Requirement Using Marx v. Akers

We covered Marx v. Akers in my Corporations class this past week, and I felt like I could have done a better job explaining the case so I thought I’d post an analysis for my weekly contribution here, which I will be able to share with my students.  If you have any comments, I’d appreciate it if you emailed them to me directly at, in addition to posting them here.

We start with the basic proposition that when a corporation has a valid legal claim, the decision whether to pursue that claim is first and foremost a business decision.  As such, it rests in the first instance with the board of directors.  However, because there are times when we may be suspicious of a board’s ability to exercise its discretion in good faith (e.g., when the claim is against members of the board itself), we also allow shareholders to bring such claims derivatively on behalf of the corporation. This right to file a derivative suit then raises its own concerns, particularly that a frivolous suit may be brought purely for settlement value.  Accordingly, various procedural hurdles are placed in the way of shareholders filing a derivative suit, including the requirement that they first make demand on the board to bring the claim directly.  In Marx v. Akers, 88 N.Y. 2d 189, we see the New York Court of Appeals deal with a variety of issues related to this demand requirement.

The court first notes that some jurisdictions impose a universal demand requirement, consistent with the approach followed by the Model Business Corporation Act.  This approach is to be distinguished from one that allows shareholders to forgo making demand where to do so would be futile.  One of the justification for a universal demand requirement is that litigation resolving the issue whether demand is excused is avoided.  As the Marx court noted:

A universal demand requirement would dispense with the necessity of making case-specific determinations and impose an easily applied bright line rule. The Business Law Section of the American Bar Association has proposed requiring a demand in all cases, without exception, and [prohibits] the commencement of a derivative proceeding within 90 days of the demand unless the demand is rejected earlier (Model Business Corporation Act § 7.42 [1] [1995 Supp]). However, plaintiffs may file suit before the expiration of 90 days, even if their demand has not been rejected, if the corporation would suffer irreparable injury as a result [of waiting the 90 days] (Model Business Corporation Act § 7.42 [2]).

Critics have argued that little is gained via a universal demand requirement because many, if not all, the same questions will likely need to be addressed later in the proceedings anyway.  When I reached out to Joan Heminway for comments on this post, she noted the following:

When I note this criticism, I sometimes ask my students to question its validity.  Consider, e.g., the circumstances where the court allows the suit to proceed because demand is excused as futile.  There then can be a separate battle over a special committee decision to move to dismiss and a substantive trial if that motion fails.  So, given the court's differing, yet similarly rooted, standards for excuse and dismissal, do we really need both of those steps?  Why isn't universal demand the answer?  What lobby/ies is/are fighting to maintain the non-mandatory demand in Delaware and elsewhere?  Does it serve any useful purpose other than giving plaintiffs more of an element of surprise and fattening the wallets of litigators?

Given that most of the decisive battles in this area in Delaware currently appear to be fought over whether demand was excused (a well-advised plaintiff would rarely, if ever, make demand in Delaware because state law there provides that by doing so the plaintiff waives the right to challenge the disinterestedness of the board later), and most of those battles apparently end up with plaintiffs losing, one can certainly question who most benefits from such a structure and how a universal demand requirement might shift the balance of power.  Regardless, the Marx court noted that it was for the legislature to decide whether New York was going to impose a universal demand requirement, and so it proceeded to delve into demand futility.  (It is worth noting here, as indicated above, that there are basically 3 related suits in this area (only some of which will be argued in any particular case): (1) challenging a board’s decision to reject demand where demand has been made and rejected; (2) challenging the futility of demand where the plaintiff claims the right to proceed without making demand; and (3) challenging the ability of a special litigation committee to dismiss a claim even where demand has been excused.  All of these are in addition to the actual underlying claim itself.  We are focusing here on the demand futility analysis.)

The court started by noting the Delaware approach to analyzing whether demand is excused, as set forth in Aronson v. Lewis:

Plaintiffs must allege particularized facts which create a reasonable doubt that, (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board’s approval thereof.

While consistent with the general rule, this formulation raises a number of additional issues.  First, is a “reasonable doubt” standard appropriate?  The Marx court chose instead to merely require plaintiff to plead the relevant elements with particularity, noting:

The reasonable doubt threshold of Delaware’s two-fold approach to demand futility has been criticized. The use of a standard of proof which is the heart of a jury’s determination in a criminal case has raised questions concerning its applicability in the corporate context. The reasonable doubt standard has also been criticized as overly subjective, thereby permitting a wide variance in the application of Delaware law to similar facts ….

Second, what is the role of “substantive care”?  As the Marx court put it: “Whether a board has validly exercised its business judgment must be evaluated by determining whether the directors exercised procedural (informed decision) and substantive (terms of the transaction) due care.”  However, a later Delaware decision expressly rejected a role for substantive care: “As for the plaintiffs' contention that the directors failed to exercise ‘substantive due care,’ we should note that such a concept is foreign to the business judgment rule…. Due care in the decisionmaking context is process due care only.”  (Brehm v. Eisner, 746 A.2d 244.)

Some additional caveats are worth noting here: (A) The Brehm court’s formulation embodies what is meant by the statement that the business judgment rule is about process only.  (B) The distinction between process-only review and a standard of review including a substantive care analysis may be less dramatic than the Brehm court implies.  As the Brehm court itself went on to note: “Irrationality is the outer limit of the business judgment rule. Irrationality may be the functional equivalent of the waste test or it may tend to show that the decision is not made in good faith, which is a key ingredient of the business judgment rule.”  In other words, while a plaintiff in Delaware may not be able to argue substantive due care, they will be able to argue waste—which may frequently be the same thing in application.  (C) Delaware actually recognizes what may be deemed a heightened substantive due care analysis when a special litigation committee is seeking to dismiss a shareholder derivative suit brought where demand has been excused (Zapata v. Maldonado).

Finally, what happens if the board that would respond to demand is not the same board that authorized the underlying transaction being challenged.  At least one answer to that question was provided by the Supreme Court of Delaware in Rales v. Blasband, 634 A.2d 927:

Consistent with the context and rationale of the Aronson decision, a court should not apply the Aronson test for demand futility where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit. This situation would arise in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where, as here, the decision being challenged was made by the board of a different corporation. Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.

In other words, only the first prong of the Aronson test is applicable in these circumstances.  A conclusion to which RTB's own Jay Brown added the following:

The first prong of Aronson and the test in Rales looks to the independence of the board.  Here is where, in my opinion, the reasonable doubt standard has been abused.  Time and time again shareholders raise issues with respect to board independence (friendship in Beam, directors who serve on boards of non-profits that receive significant contributions from the company in Goldman, outside lawyers whose firm receives significant fees in Disney).  All of these failed at the demand futility stage.  In other words, the courts with respect to demand futility apply a much higher standard than reasonable doubt.  Moreover, in Beam, the friendship between Martha Stewart and Darla Moore (in which Moore described herself in a magazine article as a best friend of Stewart) could only be explored through discovery since relevant information is not typically in the public domain.

The failing for me of the Aronson/Rales approach is that in fact directors who are not independent (or, more accurately, directors where there is a reasonable doubt about independence) are left with the decision about whether to bring a case. 

So, there you have it.  Crystal clear, right?


Amicus Briefs Filed in Conflicts Minerals Case Provide Multiple Arguments Against the Rule

Amicus briefs are being filed in the case challenging Section 1502 of Dodd-Frank and the SEC rule implementing that section (the “conflict minerals rule).  To date, the briefs support the petitioners seeking to overturn the final SEC rule on the ground that it is arbitrary and capricious.  Each brief alleges that the SEC failed to conduct sufficient analysis of the impact of the conflict minerals rule, as required by law. Specifically, the premise of each brief proceeds from a charge that in drafting its final rule implementing the conflict minerals rule:

the SEC had a “statutory obligation to determine as best as it can the economic implications of the rule.” Business Roundtable v. SEC, 647 F.3d 1144, 1148 (D.C. Cir. 2011). As this Court has repeatedly explained, “the Commission has a unique obligation to consider the effect of the new rule upon 'efficiency, competition, and capital formation' ... and its failure to 'apprise itself –and hence the public and the Congress - of the economic consequences of a proposed regulation makes promulgation of the rule arbitrary and capricious and not in accordance with law.” Id. (citing cases); see also American Equity Inv. Life Ins. Co. v. SEC, 613 F.3d 166, 176-79 (D.C.).  By its own admission the SEC has failed to fulfill this statutory obligation. The Commission acknowledged that it did not conduct any analysis of the specific costs or benefits of the numerous decisions made by the Commission in determining which products and markets would be within the scope of the [conflict minerals rule] due diligence and reporting requirements. In its discussions of the “benefits and costs resulting from the Commission's exercise of discretion” the Commission instead stated: “We are unable to quantify the impact of each of the decisions we discuss below with any precision because reliable, empirical evidence regarding the effects is not readily available to the Commission, and commentators did not provide sufficient information to allow us to do so.” Conflict Minerals Rule, 77 Fed. Reg. 56,274, 56342 (Sept. 12, 2012).


Each brief then assets very different arguments as to why the analysis done by the SEC was insufficient.  One brief, filed by a group representing an industry coalition consisting of among others, the American Coatings Association, Inc., the American Chemistry Council, the Can Manufacturers Institute, the Consumer Specialty Products Association and the National Retail Federation, focuses on the alleged failure of the SEC to assess adequately the costs the conflicts minerals rule would impose upon a broad swath of industry participants and other users (however inadvertently) of conflict minerals.  Its brief, available here stresses, among other points, that by failing to allow a de minimus exception to the rules disclosure requirements, the SEC imposed “wholly unreasonable and burdensome requirements on manufacturers who do not make significant use of conflict minerals in their products, but whose products may (or may not) contain trace elements of such minerals (which most often will not originate in the Congo) as a result of manufacturing processes (e.g., the use of catalysts) employed by third party suppliers of ingredient materials at one stage, or more, in long upstream supply chains.”  The brief provides examples of ways in which the conflict minerals rule may impose

wholly unreasonable and burdensome requirements on manufacturers who do not make significant use of conflict minerals in their products, but whose products may (or may not) contain trace elements of such minerals (which most often will not originate in the Congo) as a result of manufacturing processes (e.g., the use of catalysts) employed by third party suppliers of ingredient materials at one stage, or more, in long upstream supply chains.

The second brief, filed by a group of experts on the Democratic Republic of the Congo (“DRC”) available here focusses its arguments not on the economic impact the conflict minerals rule will have on issuers subject to its requirements, but on the impact the rule will have within the DRC.  The thrust of the argument is that the final rule as drafting by the SEC not only increases the burdens imposed by Section 1502 without warrant, but also reduces the rule’s chances of undermining armed groups in the DRC.

The experts assert that

Based on their expertise, amici believe that the SEC erred in failing to consider whether its final rule would advance Section 1502’s objective of weakening armed groups in the DRC. They further believe that the SEC compounded that error by exercising its discretion in ways that render its rule more likely to harm legitimate economic activity.

The brief assets that Section 1502 has caused the collapse of the market for anything but verifiably “conflict-free” minerals and has also had the perverse effect of further undercutting traceability programs and encouraging smuggling. Pressure to produce certifiably “conflict free” minerals has created more incentives to corrupt traceability initiatives, for instance by using stolen “conflict-free” tags.

Under the conflict minerals rule, according the experts, the costs of complying with the rule will incentivize companies to avoid being subject to compliance requirements and seek minerals elsewhere. They state that “[a]s the SEC acknowledged, “[t]he high cost of compliance provides an incentive for issuers to choose only suppliers that obtain their minerals exclusively from outside the [DRC and its neighbors], thereby avoiding the need to prepare a Conflict Minerals Report.”

There may well be more amici briefs to come and many more arguments raised both in support of and in objection to the conflict minerals rule.  At this point, the voices against the rule are sounding the loudest.


Listing Standards, Director Independence, and the Obligation to Consider Personal and Business Relationships

As we have discussed extensively on this Blog, the stock exchanges recently adopted listing standards that govern compensation committees.  As part of the listing standards, the exchanges were required to set out the relevant factors that the board had to consider in determining director independence. 

The Commission in the adopting release for Rule 10C-1 instructed the exchanges to consider whether the factors should include "personal and business" relationships between directors and executive officers.  Commentators on the proposed listing standards recommended that the factor be included.  The NYSE acknowledged that the board was required to consider personal and business relationships when determining independence. 

Nonetheless, the exchanges opted not to include personal and business relationships as an explicit factor.  They took the position that that listing standards already required board consideration of these relationships and, as a result, they did not need to be explicitly included in the standard.  See NYSE Comment Letter ("Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary."). 

The Commission, in adopting these standards, stated specifically that these factors had to be considered.  As the Commission explained:

Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board.

The comment by the SEC clarified the need to consider these factors.  Yet the factor did not actually appear in the listing standard.  The "geography" of the requirement, however, matters and the failure of the Commission to require explicit inclusion in the listing standard may impair compliance.  

In complying with annual legal requirements, directors are typically given a questionnaire and asked for the relevant information.  See In re WR Grace & Co., 53 SEC 235, 240 (1997) ("The Company provided Grace, Jr. with directors' and officers' questionnaires ("D&O Questionnaires') in the course of preparing its 1992 Form 10-K and 1993 proxy statement and its 1993 Form 10-K and 1994 proxy statement.").  Often, these forms track the language in the relevant statutes or listing requirements. 

Because the listing requirements do not explicitly refer to “personal and business” relationships, some questionnaires may not specifically ask for the information.  They may simply request that directors disclose "material relationships with the issuer."  Directors may not realize that they have to set out  personal and business relationships with executive officers.  The result is that the factors will not be disclosed to, or considered by, the board when determining director independence.

Lawyers who know about the requirement will presumably insure that the factor is covered by the D&O Questionnaire.  Less aware lawyers may not.


Mary Jo White, the SEC, and the Strategy of a Divided Commission

Mary Jo White is a partner at Debevoise.  In her confirmation related documents, she has addressed her relationship with the firm.  According to published reports, Mary Jo White has stated that she will not "participate in matters related to Debevoise or former clients for two years."

Ordinarily, this would be a minor matter.  Presumably all commissioners who join the SEC from a law firm recuse themselves for some period of time from matters that involve their law firm or former clients.  But recusal today has to be considered in the context of an increasingly divided SEC.

The Exchange Act provides that no more than three commissioners can be from the same party.  Traditionally, this means that the party of the president has three members and the minority party two members.  Its not always quite this symmetrical.  During the years of Mary Schapiro, the Commission consisted of two democrats, two republicans and one independent (Mary Schapiro).  Nonetheless, for the most part, the three two ratio remains in place.

Although there are two members of the minority party, the president has to appoint them.  As a result, there is always the possibility that the representatives of the minority party are members in name only but really reflect the views of the president.  If that is the case, one commissioner recusing him or herself on a regular basis hardly matters.

In recent years, however, the members of the minority party have been real representatives of their party, with views often in contrast to the president.  This was true under President Bush with respect to the appointees who were democrats and under President Obama with respect to the appointees who were (and are) republicans. 

While the Commission presumably approves matters for the most part unanimously there have been what appears to be an increasing number of 3-2 votes.  There are no public records with respect to enforcement proceedings (those matters are handled at meetings closed to the public) but matters sometimes leak to the press.  Moreover, with matters addressed at public meetings, divided votes seem more common

It is reasonable to assume that the sharp division in the Commission will continue.  This is something relevant to those subject to SEC investigations and enforcement proceedings.  Litigants before the Commission may sometimes have a rational incentive to embark on a strategy designed to disqualify a commissioner from the majority party.  To the extent the Commission had all five member, it could result in an evenly balanced Commission at the time a recommendation was considered.  To the extent the enforcement recommendation divided the Commission based upon party, the recommendation would not get a majority and, as a result, not be approved. 

All of this brings us back to Mary Jo White's two year recusal from cases involving Debevoise.  Litigants are in a position to retain the law firm and thereby eliminate one commissioner from the decision making process with respect to any enforcement recommendation.  In theory, this could result in a divided Commission.  Alternatively, it could result in a settlement strategy by the staff that is designed to assuage any concerns by the members of the minority party.  Either way it could affect the outcome of the case. 

Lets be clear.  This is not a strategy that has any certainty of success.  For one thing, the Commission may not be so sharply divided.  A recusal may make no difference.  For another. the recusal period is two years.  In at least some cases, the investigations will last longer than two years, with the recusal period having expired when the case makes it to the Commission.  Moreover, the longer she serves as chair, the shorter the remaining recusal period will be.

Its appropriate for commissioners coming from law firms to agree to a recusal period.  But in a divided Commission, it could have significant consequences.  


Benefit Corporations Expand but not Without Criticism (Part Two)

Despite the growing support for and recognition of benefit corporations, not all are enthused about this new business entity form.   Some question the need for a special “benefit” designation noting that any corporation can choose to be socially responsible.  Many firms today that are not “benefit corporations” pursuant to relevant statute still seek to promote social goals.  For example Target gives 5% of store profits to local causes.   Pepsi chose not to advertise in the 2010 Super Bowl but rather used those anticipated advertising costs to fund various socially-beneficial projects through its Pepsi Refresh campaign.  Chipotle advertises organic products and costs more than Taco Bell. Starbucks advertises “sustainably grown coffee” that costs more than the gas station alternative. Clearly for profit corporations can today do good and be socially responsible.

Further, to the extent that the social benefit identified by a benefit corporation requires the corporation to make large contributions to various causes it may run into tax issues.  It is not at all clear (in fact it seems unlikely) that such contributions would be deductible since it is likely questionable whether a sizeable contribution by a for-profit corporation would be an “ordinary and necessary business expense” IRC §162(a). Business gifts are limited to $25 per recipient per year. IRC §274(b)(1).  Further,  the deductibility of corporate charitable contributions is limited to 10% of taxable income each year. IRC §170(b)(2).

If benefit corporation status is granted, problems with assessment are likely.  From an external perspective, investors and others may not be aware of the choice of form.  There is no way to distinguish a Benefit Corporation from any other corporation established under state corporation codes without a close analysis of their charter documents.  Internally, how, exactly, does an entity determine the extent to which it has promoted “a material, positive impact on society and the environment” is not clear.

For now, most benefit corporation statutes leave that determination to  the review of an unidentified, non-governmental third party. (which is often B Lab—the very entity encouraging the passage of benefit corporation legislation in the first instance).  The recent problems with private third-party ratings agencies to maintain independence and provide consumer protection, suggests that this may not be the best solution.  Further, most legislation provides no guidance to any rating agency.  There is no suggested criterion or standard by which benefit corporations are to be evaluated.

The lack of governmental oversight causes concern to some critics of the form who worry that the benefit corporation format could allow bad actors to mislead the public and could give investors a false sense of security. Because the new form is not monitored by government agencies to ensure compliance with statutory requirements there is little official oversight of benefit corporations operations or adherence to their stated mission. “They have to promise to do good but they don’t have to do good” said Jan Masaoka, the CEO of the California Association of Nonprofits. 

 Benefit corporations that elect a specific public benefit may face unintended consequences. Depending on the identified benefit, the relevance or usefulness of pursuing that specific public benefit may go away if the objective is achieved.  Alternatively, the corporation may experience mission creep or mission fatigue, problems not uncommon at non-profits targeting specific social goals.   At that point, what happens?  Do the shareholders then vote to choose a new specific public benefit or revert to a traditional corporation? Does this create regulatory responsibility and associated costs to ensure that Benefit Corporations select a new specific public benefit?

Whether these concerns outweigh the advantages of benefit corporation status is a topic for debate.  At the least it suggests that state legislatures considering enacting benefit corporation legislation proceed with caution and deliberation.


Benefit Corporations Expand but not Without Criticism (Part 1)

Benefit corporations, for-profit companies that also have social or environmental missions are being legally recognized in an increasing number of jurisdictions.  With Pennsylvania coming on board in January 2012, twelve states currently have enacted legislation allowing for the creation of such corporations and many more are in the process of considering enactment of benefit corporation statutes. To some extent, this spread is not surprising.  Companies are aware that consumers increasingly emphasize elements of corporate social responsibility when making purchasing decisions and are eager to self-identify themselves as good corporate citizens. (See, Urša Golob, Marko Lah & Zlatko JančičValue orientations and consumer expectations of Corporate Social Responsibility.) From the political perspective, what state legislator would block a statute that “officially recognize[s] companies with a conscience.”  As New York Senator Daniel Squadron stated when New York adopted benefit corporation legislation “[t]here's no reason that you can't care about the world and also care about your own business.” 

In light of the growing interest in benefit corporations, it is worth understanding a bit about their legal structure, the perceived advantages they offer over a traditional corporation or non-profit entity and the criticisms being leveled against them. 

First, as to the legal structure of benefit corporations, it must be noted that the precise requirements of each jurisdictions’ legislation varies, but great commonality exists as many jurisdictions simply adopted in large part model legislation proposed by B Lab, one of the chief drivers of benefit corporation legislation.  B Lab is a non-governmental party that offers to serve as the outside annual reviewer of benefit corporations—for a fee.

Generally, benefit corporations operate just as ordinary corporations do which frees them from the constraints placed on non-profits. Benefit corporations can engage in ordinary market activities and can issue stock which provides them with access to traditional funding sources.

Benefit corporation statutes require that benefit corporations have a stated purpose of creating “general public benefit” and permit them to identify one or more “specific public benefit” purposes.  Examples of specific public benefits include

(1) Providing low-income or underserved individuals or communities with beneficial products or services;

(2) Promoting economic opportunity for individuals or communities beyond

the creation of jobs in the ordinary course of business;

(3) Preserving the environment;

(4) Improving human health;

(5) Promoting the arts, sciences, or advancement of knowledge;

(6) Increasing the flow of capital to entities with a public benefit purpose; or

(7) The accomplishment of any other particular benefit for society or the environment.

Directors of benefit corporations are required to consider a much broader range of stakeholder interests when making business decision.  Specifically, they must consider, among others, the interests of (i) shareholders, (ii) employees and workforce, (iii) customers, (iv) community and societal factors, (v) the local and global environment, and (vi) benefit corporation itself including any benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the benefit corporation.

To become a benefit, two-thirds of a corporation’s shareholders’ must vote to elect the status.  Benefit corporation status must be noted in the articles of incorporation.  If benefit corporation status is elected, the corporation must deliver an annual benefit report to the shareholders, post it on its website and file it with the appropriate department of the jurisdiction.  The annual report must include, among other disclosures, “an assessment of the overall social and environmental performance of the benefit corporation against a third-party standard applied consistently with any application of that standard in prior benefit.

Benefit corporation legislation formally recognizes a growing trend in business as more and more companies seek to be viewed as socially and environmentally responsible. In theory, it allows a corporation’s directors to consider non-financial interests when making decisions without fear of breaching any fiduciary duty to shareholders—a perceived advantage to the traditional corporate form.  It also provides a signaling mechanism to the market that a benefit corporation takes its corporate social responsibility seriously.

In addition to these “advantages” some, although not many, jurisdictions are considering granting benefit corporations special tax benefits and other privileges. For example, Philadelphia voted to run a pilot program under which certified B Corporations would receive a $4,000 tax incentive as a means to reward companies engaging in sustainable business practices.  B corporations may or may not be benefit corporations but instead are corporations that have been certified by B Lab as meeting the criteria that apply to benefit corporations. In other words, a B Corporation has no legal status whereas a benefit corporation is created pursuant to state statute.

All of the above suggests that benefit corporation legislation should be non-controversial and that we should expect it to be adopted nationwide.  This may or may not occur, but there has been some resistance to the model legislation proposed by B Lab and some push back against the very notion of benefit corporations.


Delaware, Director Independence, and Personal Relationships

The stock exchanges just declined in their listing standards to explicitly include "personal and business relationships" between management and directors as a relevant factor in determining independence.  The main reason for not doing so is that directors already have to consider any material relationships.  By implication they already have to weigh personal and business connections between officers and directors. 

In the absence of an explicit standard, however, boards may be influenced by the standard for director independence used state law.  In Delaware, personal relationships are almost never material in the determination of independence.  The state law standard was set down in Beam v. Stewart, 845 A.2d. 1040 (Del. 2004).  In that case, the Court set out a test that could almost never be met both because of the standard adopted and because of the pleading burden. 

As the Supreme Court reasoned: 

To create a reasonable doubt about an outside director's independence, a plaintiff must plead facts that would support the inference that because of the nature of a relationship or additional circumstances other than the interested director's stock ownership or voting power, the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.

In Beam, the Court found that evidence suggesting a close friendship between a director and CEO was not material.  Moreover, the Court rejected even the possibility that personal relationships could arise from interaction on the board, characterizing them as structural bias.  The Court's approach effectively imposed a standard that made friendship and other non-family personal relationships irrelevant to an independence determination.  

A reminder of the irrelevance of personal relationships at the state level occurred in In re Bj's Wholesale Club S'holders Litig., 2013 Del. Ch. LEXIS 28 (Del. Ch. Jan. 31, 2013).   In that case, plaintiffs challenged the independence of the board.  One of the directors was alleged to have had a disqualifying personal relationship.  The court summarily dismissed the contention.  "This type of allegation does not raise a reasonable doubt as to the independence of a director under Delaware law."  

The authority?  Beam.  And in describing the lesson from Beam, the Chancery Court characterized the decision as one where "directors were independent despite having longstanding personal and professional relationships to allegedly interested directors".  In other words, the court read Beam to hold that "longstanding personal and professional" relationships were not enough to impair independence.    

The SEC has made clear that the relationships have to be considered in determining director independence.  See Exchange Act Release No. 68639 (Jan. 11, 2013) ("Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board."). 

The standards at state law will not necessarily provide comfort to boards applying listing standards imposed by the exchanges.  Moreover, to the extent directors with strong personal and business ties to management are characterized as independent in proxy statements, the company may find itself susceptible to a cause of action under the antifraud provisions, irrespective of the opinion of the Delaware courts.   


Fox & Wolf on Protecting Director Compensation Plans From Entire Fairness Review

Over at The CLS Blue Sky Blog, David Fox and Daniel Wolf recently posted an interesting piece entitled, “Seinfeld and Director Compensation: A Decision That Wasn’t About Nothing.”  What follows is an excerpt of their opening overview of Seinfeld.  Go read the entire post to find out how they recommend companies deal with that decision this proxy season.

Until Seinfeld, boards of directors generally believed they were protected by the fairly lenient business judgment rule when granting themselves awards under stockholder approved plans. In the 1999 Chancery Court decision In Re 3COM, then Vice Chancellor  Steele held that the business judgment rule should apply to director option grants so long as the grants were made under a plan that had been previously approved by stockholders and had “sufficiently defined terms”….

In finding that the board in Seinfeld was interested in the equity grant, Vice Chancellor Glasscock focused on the “sufficiently defined terms” requirement from 3COM and found that the plan in question lacked the definition and limitations necessary to allow the board’s compensation decision to qualify for business judgment rule protection, notwithstanding prior stockholder approval of the plan….

In questioning the board’s reliance on the plan, Vice Chancellor Glasscock said, “Though the stockholders approved this plan, there must be some meaningful limit imposed by the stockholders on the board for the plan to be consecrated by 3COM and receive the blessing of the business judgment rule, else the ‘sufficiently defined terms’ language of 3COM is rendered toothless.”


Corporate Governance, Rule 10C-1, and the SEC: Conclusion (Part 9)

Why did the SEC not require that fees for service on the board be included or that the board explicitly consider personal and business relationships between the directors on the compensation committee and executive management?

SEC was apparently convinced by the arguments made by the exchanges.  But with respect to personal and business relationships, the SEC in the case of both rules actually mandated that the factors be considered.  What the Commission did not do was require that the consideration be explicit.  It was enough to have an isolated statement by the Commission buried in a rulemaking release. 

With respect to compensation, the exchanges did not even address the argument that boards were required by Congress to consider the fees paid to directors (or the method of determining the fees).  Even if the exchanges were convincing that it was unnecessary to consider the information, the decision was not discretionary.  Congress required consideration of fees.  The Commission simply ignored the point.

The rules, therefore, reflect a Commission unwilling to use the discretion given to it by Congress to take an active role in defining director independence.  For the most part, the exchanges determined the standards and merely duplicated the language included in the statute.  

There are a few possible explanations for the Commission's stance.  First, this is a matter of substantive corporate governance, something well beyond the usual disclosure mission of the Commission.  Substantive regulation of corporate governance is a new area for the Commission and not one where it has historic expertise.  The approach taken in connection with Rule 10C-1 could reflect an unwillingness to delve any deeper into the substance of corporate governance than the minimum prescribed by Congress. 

This attitude will have to change.  Congress gave the SEC substantive authority over governance in SOX and did it again in Dodd-Frank.  SOX gave the SEC control over audit committees and clawbacks of compensation (with the Commission slow to use the latter).  In Dodd-Frank, the SEC received authority over compensation committees, strengthened clawback authority, rulemaking power to adopt a shareholder access rule, and an obligation to adopt disclosure requirements in the area of conflict mineral and resource extraction payments. Congress clearly expects the SEC to be more involved in the substance of corporate governance.

Second, the explanation may have a structural explanation.  The SEC is sometimes described as a collection of silos that do not always talk to each other.  The requirements in Rule 10C-1 may have foundered on the silo structure. 

Because the matter is a listing standard, it falls under the jurisdiction of Trading and Markets.  That is the division with the authority to oversee the exchanges and self regulatory organizations.  With respect to trading behavior or broker oversight, Trading and Markets has expertise over the content of the rule proposal. 

This is not really true with respect to listing standards.  The content of the listing standard adopted under Rule 10C-1 affects issuers.  Issuer behavior at the Commission is mostly a matter for the Division of Corporation Finance.  That Division has the expertise over matters that affect board behavior. 

Yet the rule was approved by Trading and Markets.  The adopting releases do not reveal any involvement by Corp-Fin.  Trading and Markets has responsibility not because it has expertise over the contents but because the rule originated from an exchange.  Thus, when the exchanges make representations about the behavior of issuers with respect to the determination of directors fees, Trading and Markets has little expertise in assessing the statement. 

All of this suggests that as Congress imposes on the Commission greater and greater involvement in the substance of corporate governance, the SEC will need to consider possible reorganizations.  Implementation and review should go to (or at least involve) the Divisions with the substantive expertise on the subject, not the Divisions that have, for historical reasons, handled the issues in the past. 


Corporate Governance, Rule 10C-1, and the SEC: The NYSE, Director Independence, and the Need to Consider Directors Fees (Part 8) 

Section 10C required that the exchanges devise a listing standard that set out the "relevant factors" for determining director independence on the compensation committee.  The statute listed two of them:  Affiliations with the issuer and compensation.

In referencing compensation, boards were required to consider "the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the listed company to such director."  The plain language required consideration of all compensation, including compensation from sources other than the issuer and fees paid for service on the board. 

The legislative history also made this broad approach to compensation clear.  Congress considered language that would have limited consideration to consulting, advisory or compensatory fees and would not have involved consideration of fees paid for service on the board.  This was the approach taken in Section 10A for audit committees.  Congress, however, did not adopt this approach with respect to compensation committees.  Moreover, in broadening the types of compensation, Congress only required that they be considered.  Under the standard, no particular type or amount of compensation would automatically disqualify a director as independent.  For a more detailed discussion of this issue, go here

The NYSE (and Nasdaq) took the position that fees did not have to be considered.  As the exchange described

The Exchange does not believe that it is appropriate to consider board compensation as part of the compensation committee independence determination with respect to individual directors. Non-executive directors devote considerable time to the affairs of the companies on whose boards they sit and eligible candidates would be difficult to find if board and committee service were unpaid in nature. Consequently, independent directors of listed companies are almost invariably paid for their board and committee service. As all independent directors are almost certainly going to receive board compensation from the company and do so on terms determined by the board as a whole, the Exchange does not believe that an analysis of the board compensation of individual directors is a meaningful consideration in determining their independence for purposes of compensation committee service.

The position, however, was challenged.  In response to comments on the position, the NYSE refined its analysis somewhat.   As the NYSE letter stated:

Brown, the AFL-CIO and IBT all argue that director fees should be an explicit required factor in compensation committee independence determinations. As all non-management directors of a listed company are eligible to receive the same fees for service as a director or board committee member, the NYSE Exchanges do not believe that it is likely that director compensation would be a relevant consideration for compensation committee independence. However, the proposed rules require the board to consider all relevant factors in making compensation committee independence determinations. Therefore, to the extent that excessive board compensation might affect a director’s independence, the proposed rules would require the board to consider that factor in its determination.

Neither explanation addressed the language of Section 10C and the legislative history.  To the extent Congress required consideration of fees, the "belief" by the exchange in the unimportance of the analysis was not sufficient to override congressional intent.  Moreover, the "belief" was belied by the fact that the materiality of fees has become a much litigated issue in state courts.  See Freedman v. Adams, 2012 Del. Ch. LEXIS 74  (Del. Ch. March 30, 2012). 

Moreover, the characterization that "all" non-management directors are eligible to receive the same fees is not entirely accurate.  On many boards, directors do not receive identical fees.  In addition to fees for attending board meetings, boards can provide additional payments for serving on committees, chairing committees, and acting as lead director.  Because the definition of director independence varies (one definition applies to the board, another to the audit committee, and another to the compensation committee), not all directors will be eligible to participate in all functions and all committees.  In other words, they will not be eligible to receive the same compensation. 

Moreover, some boards pay very high fees to the lead directors.  As one survey noted:  "The extra compensation received by lead directors for their service in this capacity showed considerable variability, with 40% of respondents receiving $15,000 or less, 28% of lead directors receiving between $20,000 and $38,000, and 32% receiving compensation ranging from $50,000 to $150,000."  To the extent that the compensation committee determines the amount paid to the lead director, the lead director may not be independent for purposes of compensation decisions. 

In the second statement, however, the NYSE backed away from its earlier contention that it was not "appropriate to consider board compensation as part of the compensation committee independence determination with respect to individual directors."  While reiterating its belief that fees were not a meaningful consideration, the NYSE noted that boards would have to consider them if they were a relevant factor. 

The Commission affirmed the NYSE's position.  As the Commission explained:

The Commission recognizes that some commenters did not believe that the proposal went far enough because the Exchange did not adequately consider the compensation that directors receive for board or committee service in formulating its standards of independence for service on the compensation committee, and, in particular, the levels to which such compensation may rise, or otherwise favored additional requirements.  The Commission notes, however, that to the extent a conflict of interest exists because directors set their own compensation, companies must disclose director compensation, and investors will become aware of excessive or noncustomary director compensation through this means. In addition, as NYSE states, a company’s board of directors must consider all relevant factors in making compensation committee independence determinations, and if director fees could, in the opinion of the board, impair the director’s independent judgment with respect to compensation-related matters, the board could therefore consider director compensation in that context.

As with the NYSE, the Commission did not address the argument that the language of Section 10C and the legislative history required consideration of fees.  Moreover, the Commission was comforted by the fact that fees had to be disclosed and, as a result, the market would know if there were unusual or uncustomary fees.  Yet disclosure of amount may not reveal sufficient information about how the compensation was determined. 

Moreover, while the market may know that the director received excessive fees, the Commission's approach would still allow that director to sit on the compensation committee.  Congress, however, intended for that committee to be made up of only independent directors.  Congress did not opt for an approach that would allow any director to sit on the committee as long as possible conflict were disclosed. 


Corporate Governance, Rule 10C-1, and the SEC: The NYSE, Director Independence, and Personal Relationships (Part 7A)

The NYSE Listing Standard for Compensation Committees was adopted in Exchange Act Release No. 68639 (Jan. 11, 2013).  The standards are here.  The NYSE responded to some of the comments made on the proposal in a letter dated January 2013.

The NYSE provides that a director, to be independent, must have "no material relationship with the listed company."  NYSE Rule 303A.02. The language suggests that the focus for determining director independence is on relationships with the issuer. The language is susceptible to, and has been interpreted to mean, that relationships between executive officers and directors are not part of the equation.  In other words, independence turns entirely on the relationship between a director and the issuer. 

The confusion was exacerbated by the commentary to the provision.  The NYSE noted that it was impossible to list all factors that would bear "on the materiality of a director's relationship to a listed company," again emphasizing relationships to the issuer.  Moreover, in listing examples of disqualifying relationships, the comment included "commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others."  In other words, there was no mention of personal or business relationships except for the one reference to family.  But family was already required to be considered when determining whether one of the categorical exceptions to independence applied.  See NYSE Listing Standard 303A.02(b)

The listing standard and commentary to the listing standard made only one oblique reference to relationships with management.  The last sentence of the commentary noted that "as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding." 

Despite the lack of clarity, the NYSE has objected to any interpretation suggesting that business and personal relationships are not part of the independence calculation.  Nonetheless, the listing standard itself does not contain any explicit statement to that effect.  Moreover, for those relying on the plain meaning of the listing standard (material relationships with the issuer), there may be no reason to look for alternative interpretations.  

The need to add an explicit requirement that boards consider personal and business relationships between executive officers and directors in determining director independence came up in the context of the new listing standards governing compensation committees.  Section 10C of the Exchange Act and the SEC in Rule 10C-1 required the exchanges to define the "relevant factors"  used in determining independence on the compensation committee. 

Section 10C listed two of them, "the source of compensation of such director" and any affiliation with the listed company.  Congress, however, contemplated that other factors could be added to the list and the Commission left it up to the exchanges to determine whether their  definition should include other relevant factors.

In doing so, the Commission more or less instructed the exchanges to consider whether the factors should include "personal or business relationships" between directors on the compensation committee and executive management.  As the adopting release for Rule 10c-1 noted: 

in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

We will see how the exchanges responded to this advise in the next post. 


Corporate Governance, Rule 10C-1, and the SEC: Board Diversity and the NYSE (Part 6)

There is a serious problem with diversity on the board of directors.  Women (more than 50% of the population) make up somewhere around 15% of the directors on the boards of public companies.  People of color (about 35% of the population) are even less represented on corporate boards.

Why do we bring this up in a discussion on director independence?  The NYSE adopted a listing standard that is not gender neutral but assumes that directors on the compensation committee will be men.  As the standard provides:

When considering the sources of a director’s compensation in determining his independence for purposes of compensation committee service, the board should consider whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the listed company’s executive compensation. Similarly, when considering any affiliate relationship a director has with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company, in determining his independence for purposes of compensation committee service, the board should consider whether the affiliate relationship places the director under the direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair his ability to make independent judgments about the listed company’s executive compensation.

Perhaps the NYSE has deliberately exempted women from these considerations.  Or perhaps the standard was meant to reflect the facts on the ground since most directors are male.  Or perhaps it was an oversight.  Whatever the explanation, the default standard for legal requirements in 2013 is gender neutral.